Lender of Last Resort

Lender of Last Resort

A lender of last resort is the provider of liquidity to financial institutions that are experiencing financial difficultiesChapter 11Chapter 11 is a legal process that involves reorganization of a debtor’s debts and assets. It is available to individuals, sole proprietorships, partnerships, and corporations. It is most commonly used by corporations. The reorganization allows the business to continue operations but under supervision. In most developing and developed countries, the lender of last resort is the country’s central bank. The responsibility of the central bank is to prevent bank runs or panics from spreading to other banks due to a lack of liquidityRetained EarningsThe Retained Earnings formula represents all accumulated net income netted by all dividends paid to shareholders. Retained Earnings are part of equity on the balance sheet and represent the portion of the business’s profits that are not distributed as dividends to shareholders but instead are reserved for reinvestment. In the U.S., the Federal Reserve Federal Reserve (The Fed)The Federal Reserve, more commonly referred to as "The Fed," is the central bank of the United States of America and is the supreme financial authority behind the world’s largest free market economy.provides liquidity to affected banks, whose lack of liquidity is likely to affect the economy.

The last-resort lending function came into being in the late 1800s due to a series of panics that engulfed the banking industry. The panics led to the collapse of financial institutions, and this led to the loss of customers’ funds deposited in the institutions. The function aims to protect the depositors by providing temporary liquidity to the banks to sustain their operations. Although this function helped prevent the collapse of banks in the past, critics say that by providing additional liquidity, the Central Bank tempts banks to acquire more risks than necessary.

Classical Theories

The classical theory of lender of last resort was developed in the 19th century by Henry Thornton and Walter Bagehot. Both theorists stressed the need to protect the money stock, instead of individual banks, and allowing insolvent financial institutions to fail. They also advocated for the charging of penalty rates, good collateral, and accommodation of sound institutions only.

When he published “An Enquiry into the Nature and Effects of the Paper Credit of Great Britain” in 1882, Henry Thornton stated that the central bank could perform the function of lender of last resort since it had the monopoly on the issuance of banknotes. He distinguished the Bank of England’s role as a lender of last resort since it exercised the role more strictly than any other central bank before it. Thornton also articulated the “moral hazard” problem of last-resort lending, which he said would create laxity and recklessness in lending to individual banks. He said that by providing relief to poorly managed banks, other banks would take excessive speculative risks without caring about the results.

The other contributor to the classical theory was Walter Bagehot. In his 1873 book “Lombard Street,” Bagehot restated most of the points made by Thornton. He noted the Bank of England’s position as the holder of the ultimate reserve, making it different from the ordinary banks. However, he advocated for huge loans at a very high interest rate as the best solution to a banking crisis. Like Thornton, Bagehot argued that last resort lending should not be a continuous practice, but a temporary measure to manage banking panics.

Preventing Bank Runs

A bank runBank RunA bank run occurs when customers withdraw all their money simultaneously from their deposit accounts with a banking institution for fear that the institution is or might become insolvent. The situation takes place in fractional reserve banking systems where banks only maintain a small portion of their assets as cash. occurs when large numbers of customers withdraw their deposits simultaneously for fear that the bank might collapse. It occurs during periods of financial uncertainty, and a bank run in one bank quickly spreads to other banks as customers become uncertain about the safety of their deposits. Banks only keep a portion of their customer’s deposits and give the other portion out as loans, and this makes them vulnerable to panics. If customers make withdrawals beyond the bank’s reserves, the bank can become insolvent.

Cases of bank runs became prevalent during the Great Depression of the 1930s after the stock market crash. There were a series of banks runs and subsequent collapses, amidst rumors of an impending financial crisis. In a move to prevent more bank failures, the government declared a national bank holiday to allow for the inspection of banks. The government also enacted new regulations that required banks to hold a certain percentage of reserves. If the reserves are inadequate to stop a bank run, the central bank must lend the bank enough money to sustain customer withdrawals. Also, prominent cash deliveries to an affected bank can convince the depositors that the bank is not going to collapse.

Controversy

Although the central bank helped prevent bank runs previously, critics argue that the central bank should not act as a lender of last resort because of the following reasons:

#1 Moral hazard

Opponents of the function allege that commercial banks and other financial institutions are likely to make risky investments knowing that they will be bailed out if they experience financial difficulties. This was confirmed during the 2007/2008 financial crisis when banks invested in risky assets and were later bailed out by the Federal Reserve. Also, the International Financial Institution Advisory Commission accused the International Monetary Fund of bailing out banks in developing countries that were involved in risky investments. However, if the central bank fails to bail out banks affected by bank runs, the effects could exceed the moral hazard. The central bank can impose heavy penalties on banks that make intentional mistakes and enact regulations to guide banks borrowing from the central bank.

#2 Private Alternatives

Critics argue that private institutions can handle the function of lender of last resort without requiring government intervention. Before the formation of the Fed, the Suffolk Bank of Boston and the clearing-house system of New York provided banks with liquidity during bank runs. For example, the Suffolk Bank of Boston lessened the effects of the 1837-1839 financial panic by offering last-resort lending to member banks. The committee of the New York Clearing House Association also provided clearing-house loan certificates to banks as a way of managing the effects of the financial panic of 1857. Although these institutions were private-run, the critics argue that they played the role of a lender of last resort successfully without requiring the help of the government.

#3 Tough Penalty Rates

Imposing high penalties to banks borrowing from the central bank can force them to look for alternative sources of a bailout. The opponents claim that a strict penalty rate can make the central bank the very last lender of last resort. Banks would also be forced to institute internal measures to prevent a bank run for fear of paying harsh penalties for a loan that they could have maintained internally. For example, some banks keep an excess reserve beyond the central bank requirement during tough economic times when depositors’ withdrawals may exceed the usual limits. However, proponents of the lending function of the central bank observe that charging a high interest rate or penalty could make the loan too expensive to borrow, obscuring the intended purpose of the lender of last resort function.

The proper role of central banks continues to be debated. The following CFI resources provide further information to help you understand the banking system.

Other Resources

Bank of EnglandBank of EnglandThe Bank of England (BoE) is the central bank of the United Kingdom and a model on which most central banks around the world are built. Since its inception in 1694, the bank has changed from being a private bank that loaned money to the government, to being the official central bank of the United Kingdom.

European Central BankEuropean Central BankThe European Central Bank (ECB) is one of the seven institutions of the EU and the central bank for the entire Eurozone. It is one of the most critically important central banks in the world, supervising over 120 central and commercial banks in the member states.

Bank LineBank LineA "bank line" or a "Line of Credit" (LOC) is a kind of financing that is extended to an individual, corporation, or government entity, by a bank or other financial institution. This type of credit is different from term loans such as housing mortgages or car loans. Usually, the borrowers of an LOC can access the funds at any time as long as the agreed credit limit is not exceeded

Cost of DebtCost of DebtThe cost of debt is the return that a company provides to its debtholders and creditors. Cost of debt is used in WACC calculations for valuation analysis.